Earlier this week, in Liu v. SEC, the Supreme Court held that the SEC may seek "disgorgement" from a wrongdoer in a civil action, but only to the extent of the net profits from a violation and the award must benefit the victims. Unlike several other recent Supreme Court decisions, this one may look like a victory for the SEC. But partly because of the many questions it leaves unanswered, and partly because of the limits it places on the SEC's ability to seek disgorgement, the decision will likely result in fewer, and smaller, disgorgement awards in SEC enforcement actions. Whether a win or a loss for the SEC, though, Liu should result in a more principled and consistent application of the SEC's remedial authority. That's a step in the right direction.
The Exchange Act grants the SEC enforcement authority over securities law violations, including permitting the SEC to sue in federal court. If the suit is successful, the SEC can be awarded monetary penalties, injunctive relief, or equitable remedies. The specific question presented by the Liu case is whether a "disgorgement" award is a remedy typically available at equity. Disgorgement generally means requiring a wrongdoer to give up profits he or she made as a result of the wrongful conduct, though as this case shows, the term has a somewhat flexible meaning.
The Supreme Court's opinion rests on its understanding of remedies traditionally available in a court of equity (as opposed to a court of law), and whether and under what conditions disgorgement qualifies as such a remedy. As a lawyer, I find such delving into legal analysis of legal traditions fun. But you may be forgiven if you do not. I'll therefore spare you a discussion of the differences between law and equity, and skip to summarizing the Court's decision and its background before addressing its likely effects.
This case arose from an SEC suit against a couple who solicited nearly $27 million from foreign investors to build a cancer-treatment center. The couple was found to have defrauded investors, having spent only a fraction of the funds raised for legitimate purposes. They were enjoined from future participation in a foreign investor program, subjected to a monetary penalty at the highest tier authorized, and ordered to disgorge the full amount raised from the investors, minus a small sum left in their project's corporate accounts. The court held the pair jointly and severally liable, meaning that each was responsible for the full amount that the SEC sought.
While the Liu case was pending, the Supreme Court decided Kokesh v. SEC, which held that disgorgement was a "penalty" for statute of limitations purposes. Generally speaking, equitable remedies are not meant to penalize or punish. And although the Supreme Court explicitly reserved the question of whether the SEC was authorized to seek disgorgement, the Court rested its holding, in part, on findings that disgorgement is assessed, in part, for punitive purposes, and in many cases is not compensatory. Kokesh therefore seemed to sound the death knell for the SEC's disgorgement authority as an authorized equitable remedy.
When squarely faced with the question in Liu, though, the Court preserved the SEC's disgorgement authority by rewriting it. Recognizing that "equity courts have routinely deprived wrongdoers of their net profits from unlawful activity," it found that the SEC does have the right to seek disgorgement, but that this right is limited. Specifically, it held that a disgorgement-type remedy is valid when: limited to the net profits from the wrongdoing; wrongly obtained profits are returned to the wronged victims; and awarded against a single wrongdoer only, rather than jointly and severally. When the SEC seeks disgorgement beyond these limits, its practice "is in considerable tension with equity practices."
This tension is not just theoretical. The Court pointed to several examples of unwarranted SEC disgorgement awards: disgorging the profits from unlawful trades of a defendant's stockbroker, disgorging benefits conferred on close associates, and disgorging without offsetting business expenses. Another example is when disgorgement wrongfully obtained profits in Foreign Corrupt Practices Act matters where the only offense charged was recordkeeping errors that did not garner profits, as the Cato Institute pointed out in its amicus brief.
Because the defendants in the Liu case sought to have disgorgement ruled out entirely rather than reformed, the Court sent the case back to the lower courts with "principles that may guide" their consideration of an appropriate disgorgement order. These principles mirror the limitations imposed on equitable remedies: the award must be "appropriate or necessary for the benefit of the investors"; individual liability for wrongful profits; and awards must not exceed net profits. But the Court leaves several unanswered questions, including:
1.) What does it mean for a remedy to be for the "benefit of investors"? The answer to this question in the Liu decision will shape both what the SEC does with the money collected and when the SEC may seek a disgorgement award. The Court counseled that the equitable nature of disgorgement "generally requires the SEC to return a defendant's gains to the wronged investors for their benefit." While the SEC touts its return of $1.2 billion to harmed investors in 2019, that number is a fraction of the $3.2 billion of disgorgement collected that year. To comply with the Court's limitations, the SEC must do more than merely deposit the proceeds in the U.S. Treasury.
What more can it do? It seems obvious that where victims are easily identified and easily located, the money should be returned to them. But suppose an investor cannot be located. May the SEC collect the award anyway and put the funds to some other use? The Dodd-Frank Act created an "investor protection fund" that can be used for undistributed disgorgement awards. Funds deposited there are used to pay whistleblower awards, among other things. Is that "for the benefit of investors"? What about a fund set up for other purposes, like investor education? Or should disgorged funds be paid into a "fair fund" to compensate other victims? Should any of these uses be considered for the "benefit of investors," may the SEC resort to them instead of returning disgorged funds to known and located victims? And what if the victims have already been compensated through some other remedy. May the SEC still seek disgorgement?
When victims are not readily identifiable, a different set of questions arises. The SEC brings suit for a host of violations where an ill-gotten gain may be identifiable, but it is hard, if not impossible, to identify any particular victims of the violation. For example, the SEC routinely seeks disgorgement of profits in insider trading cases. Will the SEC have to forgo such awards in the future?
These and other questions are likely to give rise to significant litigation in the coming years depending on how aggressively the SEC seeks to exercise its (limited) disgorgement authority.
2.) Will the SEC be limited to "Liu disgorgement" in administrative proceedings? The Liu decision deals specifically with the question of the SEC's remedies in civil actions. But the SEC also brings suit in its own administrative tribunals. For administrative actions, the statute specifically authorizes the SEC to seek "disgorgement." The Court's opinion, however, does not address whether the limits that it applies to disgorgement as an equitable remedy will apply to disgorgement as an administrative remedy. As Justice Thomas points out in his dissenting opinion, this will "cause confusion in administrative practice," and the result may be that "disgorgement has one meaning when the SEC goes to district court and another when it proceeds in house." Besides confusion, competing definitions of disgorgement may result in a greater shift to administrative cases for certain types of misconduct. Historically, the SEC has enjoyed a significant home-field advantage in its tribunals, but that may no longer be the case. Competing definitions of disgorgement may also make settlement negotiation more difficult for those cases that do not litigate.
3.) Is disgorgement still a penalty for statute of limitation purposes? Because the Supreme Court's decision in Kokesh rested, in part, on its findings that disgorgement was punitive and often not compensatory, the lines drawn by the Court in Liu seem to make those findings obsolete. Does that mean, then, that the SEC is no longer bound by the same statute of limitations concerns for disgorgement? The SEC recognizes the significant headwinds that the Kokesh decision created for collecting disgorgement, particularly for long-running frauds. The SEC may choose to press this argument to recapture some disgorgement authority, particularly given the other limitations imposed by this decision.
All of these open questions may magnify the effects of the Liu decision's certainties—that disgorgement awards will be more limited and harder to prove. This should result in fewer, and smaller, disgorgement awards going forward. There may be a significant impact on the SEC's remedies, where disgorgement has far outpaced monetary penalties for years, accounting for 75% of monetary relief ordered in 2019.
The Court made clear that any disgorgement award will be based on a fact-intensive inquiry into the amount of wrongful gains an individual wrongdoer received. Disgorgement awards must not exceed the unlawful gains made, when both the receipts and payments are taken into account, and courts must consider whether expenses incurred have a value independent of fueling a fraudulent scheme. While not prohibiting joint-and-several liability, the Court cautioned against its use. These limitations will subject the SEC's demands to more scrutiny, even if all of the open questions break in the SEC's favor.
The Liu decision should put an end to disgorgement awards that exceed the value of illegally obtained profits. Such awards were not aimed at restoring the status quo. Instead they were punitive, leaving defendants worse off. The SEC has other tools at its disposal to penalize defendants, including monetary penalties. Liu's limitations on the SEC's discretion will force the SEC to make more clear distinctions between remedies meant to punish and remedies meant to restore the status quo. More clear lines between the two will increase transparency and consistency in the SEC's enforcement efforts, and make it easier to assess the effectiveness of the SEC's remedial tools. Liu will also likely increase the share of disgorgement awards that directly compensate victims of wrongdoing. For those reasons, Liu should be viewed as a win for us all.